Business entities engage in various activities typically reflected by their respective internal accounting systems. Periodically, the entities prepare and disseminate financial disclosures indicative of one or more financial considerations such as earnings. External parties (e.g., investors, stockholders, insurance companies, regulatory agencies, etc.) examine these disclosures to ascertain the financial health of the entities. Ideally, such examination allows the external parties to make informed business or regulatory decisions. For example, an insurance company may examine a financial disclosure of an entity in order to determine whether to insure the entity and at what premium cost.
Some business entities may engage in aggressive accounting practices that obscure their true financial health. A failure by an external party to detect this obscurity can lead to unsound business or regulatory judgments. For example, an entity may manipulate an accruals component of a financial disclosure in order to increase reported earnings, and the increased earnings may overstate the financial health of the entity. Accruals are typically associated with earnings that are not cash-based and therefore can be manipulated by, for example, managers attempting to offset poor economic performance. In other instances, adjustments of accruals can actually provide a more accurate depiction of an entity's financial health such as when, for example, accruals are adjusted to match current costs with related revenue. Whether an analyst can determine an entity's true financial health from one or more of the entity's financial disclosures may depend on the level of sophistication of the analyst and/or the quality of the analytical model that the analyst is using to examine the financial disclosures. For example, individuals who purchase stock on their own behalf may be unfamiliar with, and therefore unable to detect and/or analyze, indicators of aggressive accounting practices.
Moreover, often times it is desirable to compare the performance of entities such as, for example, entities in the same industry or entities included in the S&P 500. Such a comparison may be extremely time-consuming and/or prohibitively expensive. In particular, the comparison may require an analyst to examine manually all of the current financial disclosures of the entities in question. Additionally, the analyst may be required to possess a threshold level of sophistication to make the comparison such as when, for example, the analyst is using an analytical model that utilizes a metric which must be derived from one or more financial disclosures.
In view of the foregoing, it would be desirable to provide methods and systems for classifying entities according to metrics of earnings quality.